FINANCIAL INSTITUTION AND

INVESTMENT MANAGEMENT
Lecture
Financial Institutions in the Financial System
Course leader : Tadele Tesfay (Asst. Prof)
Financial Institutions and Capital Transfer
 The term financial institutions and financial
intermediaries are often used interchangeably.
 The financial institutions or intermediaries are
engaged in the business of channeling money from
savers to borrowers.
 This channeling process, which is known as
financial intermediation, is crucial to a well
functioning of modern economy.
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Financial Intermediaries and their Roles
 Financial intermediaries obtain funds by issuing financial
claims against themselves to market participants, then
investing those funds.
 The investment made by financial intermediaries – their
asset- can be in loans, or securities. This investment referred
to as direct investment.

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 This transformation involves at least one of the four
economic functions:
A) Providing maturity intermediation
 The deposit that commercial banks accept may have a
maturity period of short term or long term, or payable
on demand.
 On the other hand, the maturity period of the loan
made by a commercial banks may be different from the
maturity period of the deposit they accept.

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B) Risk reduction via diversification
 Diversification is the process of transforming more
risky assets into less risky assets.
 Individuals can do it by themselves but they may not
do it as cost effective as a financial intermediaries,
depending on the amount of funds they have to invest.
 Thus, attaining cost effective diversification in order to
reduce risk is an important economic function of
financial intermediaries.

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C) Reduce the cost of contracting and information
processing.
 Information processing cost is cost incurred to process the
information about the financial asset and its issuer in
addition to the opportunity cost of the time
 Contracting cost is a cost spent to write the loan contract.

 These two costs reduced through financial institutions

because of the economies of scale in contracting and
processing information about the financial assets.

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D) Providing a payment mechanism
 Most transactions made today are not done with cash.

 Instead , payments are made using checks, credit cards,

debit cards and electronic transfers of funds.
 Therefore, these methods of making payments are
provided by financial intermediaries.

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 Classifications of Financial Institutions
 Financial institutions are commonly classified as:
1. Depository institutions &
2. Non-depository institutions
1. Depository Institutions
 Depository institutions are financial
intermediaries that accept deposits.
 These deposits represent the liabilities (debts) of
the deposit accepting financial institutions.
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 With the fund raised through deposits and other
funding sources, depository institutions make
direct loans to various entities and also invest in
securities.
 Thus, their income is derived from:
 income generated from loans they make and
 income generated from the securities they purchased

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• There are some financial institutions which are
highly specialized types of depository institutions
(these are called thrifts). Example, Saving banks,
credit unions etc.
• They have not been permitted to accept deposits
transferable by check or any negotiable
instrument.
• They have obtained funds primarily by tapping
the savings of households.
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• Depository institutions are highly regulated
because of the important role that they play in
the financial system.
• Because of their important role, depository
institutions are affording special privileges such

as access to federal deposit, insurance and

access to a government entity that provides

funds for liquidity of emergency needs.

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Assets and Liability Problem of Depository Institutions
 A depository institution seeks to earn a positive
spread between the assets it invests in (loans and
securities) and the cost of its funds (deposits and
other sources).
 The spread is referred to as spread income or
margin.
 The spread income should allow the institution to
meet operating expenses and earn a fair profit on
its capital.
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 But, in generating spread income a depository institution
faces the following risks:
Credit or default risk: refers to the risk that a borrower
will default on a loan obligation to the depository
institution.
Regulatory risk: refers to the risk that regulators will
change the rules so as to impact the earnings of the
institution unfavorably.
Funding or interest rate risk: refers to the risk associated
with the amount of interest paid for depositors and
received from borrowers.
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 Example: Awash bank raises Birr 100 million by

issuing a deposit account that has a maturity period

of one year at the interest rate of 5%. Then the bank

has invested all its Birr 100 million in government

security for 10 years at the interest rate of 8%.

 In this case:

I. The income spread of a bank is known only for the first

year and it is unknown for the next 9 years.

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II. The income spread for year one is 3% (8% - 5%) and the
spread for the future (for 9 years) will depend on the
interest rate that Awash bank will have to pay to
depositors in order to raise Birr 100 million after one year.
III. Thus, if interest rates decline, the spread will increase and
if interest rates rise, the spread will decline because the
ceiling (upper interest rate) has locked to 8%.
IV. But if Awash Bank must pay more than 8% to depositors,
the spread will be negative. This is because it will cost the
bank more to finance the government securities than it
will earn on the funds invested in those securities.
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 Think about the opposite situation. A short term
loan (1 year) financed by a 5 year deposit.
 After 1 year the loan needs to be reinvested. Find
a new borrower for the next four years (i.e., from
year two up to year five).
 The interest rate might have changed. If it goes
down there will be a loss. If it goes up there will
be a profit.

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Liquidity concern
 Besides facing credit risk & interest rate risk, a
depository institution must be prepared to satisfy:
1. withdrawals of funds by depositors &
2. to provide loans to customers.

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  Depository institutions
 Non Depository institutions

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 Depositary institutions uses the following ways
to accommodate withdrawal & loan demands:
1. Attract additional deposits
2. Use existing securities as collateral for borrowing from a
federal agency or other financial institution.
 Banks have a privilege to borrow funds from central bank
at discount, when they have got shortage of liquidity.
3) Sell securities that they own
4) Raise short term funds in the money market.

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 Depository institutions are further subcategorized

depending on the market they serve, their primary source

of funding, type of ownership, how they are regulated and the

geographic extent of their market.

 Thus, depository institution includes:

a. Commercial Banks
b. Savings and Loan Associations
c. Saving Banks
d. Credit Unions
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 a. Commercial Banks
 The primary business of commercial banks is to
serve businesses.
 They provide the widest variety of banking
services.
 In addition to savings accounts, checking service,
consumer loans, industrial and commercial loans,
and credit cards, commercial banks may also offer
trade financing, investment banking and safe
keeping of valuables
.
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 Commercial banks are the largest bank, both in assets and in
geographic extent.
 They take deposit from people who want to save and use
the deposits to make loans to people who want to borrow.
Bank Services
 Commercial banks provide numerous services in the
financial system; individual services, institutional services
and global services

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 Individual banking: It encompasses consumer lending,
residential mortgage lending, consumer installment loans,
credit card financing, student loan & individual oriented
financial investment service.

 They generate:

Interest from loans

Fee income from credit card financing

 Institutional banking: loans to non-financial corporations

& financial corporations (like insurance companies),
government, leasing companies etc.
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 They generate:
 Interest from loan to corporation & leasing
 Fees from management of private assets pension
funds, custodial services.

 Global banking: It concerns a broad range of

activities involving corporate financing & capital
market & foreign exchange products & services.

 Most global banking generates fee income rather than

interest income.
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Bank Balance Sheet
 A balance sheet is a financial report that shows
the value of a company’s assets, liabilities, and
owner’s equity at a specific period of time,
usually at the end of the accounting period.
Bank Assets = Bank Liabilities + Bank Capital

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Bank Assets
 Assets earn revenue for the bank and includes cash,
securities, loans, and property and equipment that
allows it to operate.
a. Cash
 One of the major services of a bank is to supply cash on
demand, whether it is a depositor withdrawing money
or writing a check or a bank customer drawing a credit.
 Hence, a bank must maintain a certain level of cash
compared to its liabilities to maintain solvency.

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 b. Securities

 The primary securities that banks own are

Treasury Bills and Government Bonds.
 These securities can be sold quickly in the
secondary market when a bank needs more
cash.
 Therefore, they are often referred to as
secondary reserves.

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 c. Loans
 Loans are the major assets for most banks. They earn
more interest than banks have to pay on deposits, and,
thus, are a major source of revenue for a bank.
 Loans include the following major types:
 Business loans, usually called commercial and industrial
loans.
 Real estate loans, e.g., residential mortgages
 Consumer loans, e.g., credit cards
 Inter-bank loans, i.e., the loan given to other banks.

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Bank Liabilities
 Liabilities are either the deposits of customers or
money that banks borrow from other sources to use
to fund assets that earn revenue.
a. Checkable/Demand deposits
 Checkable or demand deposits are deposits where
depositors can withdraw the money at will.
 Most checkable or demand accounts pay very little
interest or no interest.
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b. Saving deposits
 Since saving accounts are not used as a payment system,
banks are forced to pay more interest for it.
 Saving deposits are mostly passbook saving accounts,
where all transactions were recorded in a passbook.
c. Fixed Deposit
 It is a deposit where the depositor agrees to keep the
money in the account until the certificate of deposit
expires.
 The bank compensates the depositor with a higher
interest rate.
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d. Borrowing
I. Banks usually borrow money from other banks in what
is called the central/federal funds market.

II. Banks also borrow funds from non-depository

institutions, such as insurance companies, pension
fund.
 However, most of these loans are collateralized in the
form of repurchase agreement, where the bank gives
the lender securities, usually Treasury bills, as
collateral for a short-term loan.
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III. As a last resort, banks can also borrow funds from
the central bank.

 But since borrowing from the central bank shows

that banks are under financial stress and unable to
get funding elsewhere, they do this rarely.

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Bank Capital

 Banks can also get more funds either from the

bank’s owners if it is a corporation or by issuing
more stocks

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 b. Saving & loan Association
 Saving and Loans Association represent a fairly
old institution.
 The basic purpose of establishing saving and
loans associations was pooling the savings of
local residents for financing the construction
and purchase of a homes.

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 The collateral for the loan would be the
home being financed.
 Saving and loans are either mutually
owned (means there is no stock
outstanding) or have corporate stock
ownership, so technically the depositors
are the owners.

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 Traditionally, the only assets in which saving
and loans associations were allowed to
invest have been:
 Mortgages (Loans secured by a property).
 Mortgage – backed securities
 Government securities

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 But, because of the mismatch of lending and borrowing
(i.e., lending long and borrowing short), they have
expanded the type of assets in which they could invest.

 Thus, the acceptable list of investment now includes:

 Consumer loans (loans for home improvements,

automobile, education, credit cards etc)

 Non-consumer loans (loans for commercial, corporate

business etc).

 Municipal securities.

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 The principal source of funds for Saving and
Loans Associations consisted of passbook savings
accounts and time deposits.
 Then it was expanded to negotiable order of
withdrawal (NOW) account, which is similar with
demand account.

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 c. Saving banks:
 Saving banks are institutions similar to saving and loans
associations even though they are much older than S &
Ls.
 Originally, they were established to provide a means for
small depositors and earn a return on their deposits.
 They can be either mutually owned (i.e., mutually saving
banks) or stockholder owned. But most saving banks are
of the mutual form.

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 Asset structure of saving banks and S & Ls are
almost similar.
 The principal assets of saving banks are
residential mortgages.
 The principal source of funds for saving banks is
deposits which is very similar with S & Ls.

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 d. Credit Unions
 They are the smallest & nonprofit depository
institution. They can obtain either a state or federal
charter.
 Their unique aspect is the “common bond”
requirement for credit union membership, such as
the employees of a particular company, unions,
religious affiliations or who live in a specific area
etc and they are governed by a board of volunteers.
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 Credit Unions are either cooperatives or mutually
owned.
 There is no corporate stock ownership. Since they
are nonprofit and owned by their customers, they
charge lower loan rates and pay higher interest
rates on savings.
 Therefore, the dual purpose of credit unions is to
serve their members saving and borrowing needs.

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Thank you!

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